Managing retirement savings in down markets

The typical 401(k) account balance fell between 19 percent and 25 percent this year through mid-October, according to the Employee Benefit Research Institute.

Conventional wisdom suggests that you stay the course and not sell out of downtrodden investments, only to see them rebound when the economy recovers.

Selling out at the lows may not be the answer, but who knows where the bottom is in these turbulent financial times?

Historically, the stock market has served as a leading indicator of what’s going on in the economy. The market declines presage a recession, but don’t predict the length or severity of the economic downturn.

Not sure what to do? Below I address several issues relevant to all investors, regardless of age. In a separate article, I offer age-specific advice about managing your retirement investments in turbulent financial times, focusing on four life stages that span from early career to retirement.

1. Keep contributing

If you’re still working, stopping contributions to your retirement account isn’t the answer. This is especially true if your company matches all or part of your contributions to a 401(k) or 403(b) plan.

Companies commonly match 50 cents on the dollar for up to 6 percent of salary contributed to the plan. That gives you a 50 percent return on your money without any angst at all about markets or investing.

Even if your employer doesn’t match your contributions, if you stop contributing, you stop working toward the goal of a financially secure retirement. You can dial down the risk in how you’re invested if that’s appropriate for your situation, but getting out of the habit of contributing creates its own set of problems down the road.

2. Stay diversified

Markets are virtually impossible to time and they don’t all move together. Being invested across markets allows you to participate in market upswings — as well as market downturns.

Financial securities are commonly broken down into stocks, bonds and cash, with cash being shorthand for investments in money market instruments — not currency. Stocks, bonds and cash represent separate asset classes, and within the stock and bond categories there are even more asset classes.

In the late ’90s, investors flocked to the stock market because of the high returns it generated. The music stopped and the stock market was no longer the place to be. In the new century, real estate came to the fore and investors focused on buying properties. Again, the music stopped, and the real estate market was no longer the place to be.

Rather than play musical chairs with your investments, invest across asset classes by diversifying your investments and periodically rebalance your holdings to bring them back to a target asset allocation.

3. Rebalance your portfolio

“No tree grows to the sun.” Rebalancing your portfolio involves pruning your winning positions and using that money to buy into underperforming assets at regular intervals to bring you back to your target asset allocation.

Calendar rebalancing takes place on a periodic basis, whether quarterly or annually. Percentage-of-portfolio rebalancing takes place when an asset group is over or under the target asset allocation by a stated percentage amount. For example, if you’re targeting stocks to be 50 percent of your portfolio and they currently represent 35 percent of your portfolio, you would need to reallocate your portfolio, bringing stocks back to 50 percent of your portfolio valuation.

In tax-advantaged retirement accounts, the tax impact of rebalancing is minimal. Consider rebalancing based on the asset allocation of all your investments and look to minimize the tax impact of changes by managing asset allocations across taxable and tax advantaged accounts. For example, you may want to keep investments taxed at ordinary rates, such as certain bonds, in your retirement account, while other investments taxed at favorable long-term capital gains rates might be kept in your taxable account.

4. Consider investment choices

If you don’t like the investment choices in your 401(k) or 403(b) plan, then work with your plan sponsor to change them. Plan sponsors are becoming increasingly receptive to feedback from participants.

Beyond choices, you also want to consider the annual fees and expenses associated with investing in the plan. Fees and expenses will always be part of the equation, but you don’t want an excessive drag on your investment returns. In recent months, regulators have focused on the issue of plan fee disclosure due in part to the spate of lawsuits filed by plan participants.

5. Determine your risk tolerance

Know how you feel about risk in investing. The “Investment Risk Tolerance Quiz” offered by Rutgers’ New Jersey Agricultural Experiment Station, can give you a quick read on your risk tolerance. It’s a quantitative approach to the “sleep number” test discussed by David Stevens in the Bankrate feature, “8 tips for investing in hard times.”

If you find yourself tossing and turning at night, and it’s not your mattress but rather the markets keeping you awake, then it’s time to dial down the risk of your portfolio.

If you’re not willing to take on much risk, then you should expect to contribute a higher percentage of your income to your retirement investments. There’s a trade-off between the willingness to accept risk in investing and the returns you can expect from investing. It’s easy to focus on the safety of principal invested, but you have to also be concerned about earning a high enough return to have that principal’s purchasing power increase with inflation. If your investments can’t keep pace with inflation, then you will fall behind in meeting your retirement goals.

6. Limit company stock exposure

You already have your human capital invested at work. Be careful about doubling down and investing too much of your financial capital at work, too. If the matching contribution made by the company is in company stock, investigate your options in managing that exposure in your retirement account. Financial advisers commonly recommend that you hold no more than 10 percent to 15 percent of your retirement monies in company stock.

7. Don’t dip into retirement accounts

Refrain from borrowing against your retirement accounts. If you get laid off from your job, most plans require that a 401(k) or 403(b) loan immediately comes due. If it’s not repaid then it is classified as a distribution and is taxable. You may also owe the 10 percent penalty tax on an early distribution.

Likewise, unless you’re up against it, don’t cash in your retirement accounts after a layoff. The distribution is taxable as ordinary income and you may owe a 10 percent penalty tax, as well. Try to keep this money working for you toward your retirement goal and don’t let Uncle Sam get the money early.

8. Re-characterize Roth IRA conversions

If you converted a traditional IRA to a Roth IRA in 2008 only to see the account decline in value in the 2008 tax year, you should to work with your tax adviser to determine if it makes financial sense to re-characterize the account as a traditional IRA. You want to look into this because the taxes due on the conversion are based on valuations on the conversion date.

Why pay income tax on losses? You can look at reconverting in 2009. IRS Publication 590, “Individual Retirement Arrangements” has all the details, but avoid the temptation to do it yourself.

9. Get professional help

A professional financial adviser can help you understand what’s going on in the markets and how the market sell-off may present opportunities for future growth.

No one knows for sure where the market is heading. You shouldn’t look for guarantees, but a financial planner can help you manage the risk you face in your portfolio while helping you to identify and work toward your life goals — including and especially retirement.

Use Bankrate’s CFP search tool to find a financial planner in your area.

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